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All's Fair in M&A?

Judges and regulators are taking aim at conflicted "fairness" opinions.
Ronald Fink, CFO Magazine
April 1, 2006

When TCI Corp. agreed to be acquired by AT&T in 1998, TCI's board got a fairness opinion on the proposed transaction from the same investment bank that recommended the $54 billion deal, Donaldson, Lufkin & Jenrette Inc. Once the deal was complete, TCI paid DLJ a handsome success fee of $40 million.

Such an arrangement has been typical since 1985, when the Delaware Supreme Court prodded dealmakers to start seeking third-party opinions of a transaction's fairness. What could be easier than getting the opinion from the investment bank that did the deal? But that could change, depending on the outcome of a shareholder lawsuit before the Delaware Chancery Court. The suit charges that because TCI's board did not hire an independent third party to produce the fairness opinion, the board violated its fiduciary duty to holders of TCI's tracking stock. Last December, Chancellor William B. Chandler III denied a defense motion to dismiss the suit.

Dealmakers were quick to react to the ruling. One New York law firm, Wachtell, Lipton, Rosen & Katz, reportedly sent a memo to clients warning that Chandler's ruling jeopardized practices commonly used in merger transactions. William McGuinness, a litigator in the New York office of Fried, Frank, Harris, Shriver & Jacobson LLP, calls the decision "an important road map on how not to handle a number of issues."

McGuinness adds that he expects the decision, along with that in another Delaware Chancery Court case last summer (see "Better a Paper Clip" at the end of this article), to prompt more directors to seek second opinions. Says Philip Wisler, a Philadelphia-based managing director in the advisory firm Duff & Phelps LLC: "Conflicts of interest are really under a spotlight."

Fairness opinions, of course, are supposed to ensure that shareholders receive a fair price for their holdings. But such opinions can add to the cost of deals, and that cost won't be recovered if a deal falls through, as John Malone, TCI's chairman and CEO at the time, pointed out to the Delaware court. "The committee had an interest in not having the big expense that was being borne by the company absent a deal," Malone testified.

Chandler, however, rejected that thinking. Getting a fairness opinion from the investment banker that recommends a deal might be cheaper and more convenient, he wrote, "but its potentially misguided recommendations could result in even higher costs" to the target company's shareholders.

Enter the Activists
The Delaware Chancery Court isn't the only powerful critic of fairness opinions offered by sources that have conflicts of interest. Last year, the NASD, the self-regulatory trade group that represents investment banks and other brokers and dealers in securities (and was formerly known as the National Association of Securities Dealers), proposed new rules that require members to disclose any conflicts they have when issuing such opinions. The rules await approval by the Securities and Exchange Commission.

The NASD took this action after seeking guidance from a variety of industry participants. But some, including institutional investors such as the California Public Employees' Retirement System, sought outright bans on deal advisers offering such opinions. And others besides investors believe the NASD's rules don't go far enough. One such critic is Jeffrey Williams, founder of a valuation firm that bears his name. Like a growing number of such firms, New York–based Jeffrey Williams & Co. makes a point of avoiding business that would compromise the independence of its opinions. Another such firm is Duff & Phelps, which no longer issues credit ratings and merged with S&P's Corporate Value Consulting Business last year expressly to beef up its valuation business.

Even some investment banks are trying to distinguish their valuation opinions from those of larger banks, which have a broader array of services and thus more potential conflicts. Increasingly, for instance, multiline banks such as Citigroup and JPMorgan Chase & Co. promise financing to buyers on deals they have recommended to sellers. While such arrangements, called "stapled financing," can smooth the way for a deal's completion, the technique was singled out for criticism last summer in a Delaware Chancery Court decision involving the leveraged buyout of Toys "R" Us, which was arranged and financed by Credit Suisse First Boston.

Conflicts Remain
Following the decision in that case, Goldman Sachs announced it would avoid financing any deals on which it offers a fairness opinion. But that's not much of a sacrifice for Goldman, since it does relatively little underwriting to begin with. And it isn't passing up advisory fees on the same deals. That was amply evident when it offered a fairness opinion on the New York Stock Exchange's acquisition later in the year of the Archipelago electronic trading system. (The investment bank, of course, also has a seat on the exchange. "Goldman was all over that deal," says Williams.)

Even more-narrowly focused M&A advisory firms, investment boutiques such as Greenhill & Co. and Evercore Partners, can still have conflicts when supplying fairness opinions, even when they are not advisers to the deal in question. That's because they may seek other, more-profitable types of business, including future M&A advisory work, from the parties to the deal, Williams points out.


But can valuation-only firms make enough profit on fairness opinions for the service to be a viable business in its own right? Williams expects the demand for such opinions will grow both in the wake of Chancellor Chandler's ruling (even if the lawsuit is ultimately lost) and if the SEC approves the NASD's rules.

Granted, some academics question the need for such opinions in the first place, arguing that investors should be able to judge for themselves whether a price is fair. Rather than focus on such opinions, these academics contend that courts and regulators should ensure that shareholders' ability to vote on deals isn't inhibited by antitakeover mechanisms such as staggered board terms and poison pills. "The answer is to make sure there's an active market for corporate control," Larry Ribstein, a law professor at the University of Illinois, recently wrote on his Weblog, Ideoblog. "If companies are auctioned freely, we don't have to worry as much about getting someone's opinion as to what the price should be."

But corporate lobbyists have successfully beaten back SEC proposals to discourage antitakeover devices. Given that, and a legal climate dominated by Sarbanes-Oxley and related efforts to eliminate or at least manage conflicts of interest more effectively, fairness opinions from advisers playing multiple roles are likely to continue to draw criticism. "The independence bubble has expanded," says Duff & Phelps's Wisler.

Ronald Fink is a deputy editor of CFO.


Better a Paper Clip

The board of Toys "R" Us fared better than TCI Corp.'s did in Delaware Chancery Court last year. But the Toys board still came in for some sharp criticism by the judge in its case, because it agreed to accept "stapled" financing for its leveraged buyout from Credit Suisse First Boston (CSFB). In such deals, banks representing sellers offer to provide financing to buyers.

Stapled financing, in fact, has become commonplace in M&A transactions during the past 18 months or so, notes Jeffrey Williams, who left Morgan Stanley in 1996 to found Jeffrey Williams & Co., a valuation advisory firm. But that didn't win Toys or its bank any respect from the chancery court.

"That decision [to provide such financing] was unfortunate," wrote Vice Chancellor Leo Strine, because it served to create "the appearance of impropriety, playing into already heightened suspicions about the ethics of investment banking firms." Instead, Strine wrote, CSFB should have "taken the position that its credibility as a sell-side adviser was too important in this case, and in general, for it to simultaneously play on the buy-side in a deal when it was the seller's financial adviser." Given CSFB's refusal to refrain, the judge said "it might have been better" if the board of Toys had declined the bank's offer. — R.F.




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